Entrepreneurship guide: Venture capital and term sheets

If you’ve got made it via the pitch course of and are on the level the place an investor has handed you a replica of a term sheet, you’ve got a proper to really feel fairly excited.

So give your self a couple of minutes to have a good time — and then get all the way down to enterprise.

While a term sheet is not a legally binding doc, it has the potential to form each future spherical of funding you elevate. It’s extraordinarily necessary to learn it rigorously, rent a lawyer that will help you perceive what you simply learn, and be sure you’re snug with every little thing in there earlier than signing your identify.

Business Insider spoke to a collection of entrepreneurship consultants — together with founders, buyers, and attorneys — about key features of the term sheet and the commonest pitfalls to keep away from. Though everybody interviewed declined to share copies of term sheets they’d signed, citing confidentiality causes, yow will discover templates on the National Venture Capital Association web site.

Read on for the very best recommendation we heard about term sheets:

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It’s simple to get slowed down in all of the legalese in a term sheet.

But ask Jerry Chen, a associate on the venture-capital agency Greylock Partners, and he’ll let you know the primary factor to deal with is the standard of the investor and the agency they work for. If you’ve got chosen somebody educated and skilled, it is unlikely they’ve included something misleading or unconventional in there.

The three key classes of phrases to evaluate, in accordance with Chen, are valuation, governance, and voting rights (extra on all these beneath). While different phrases are necessary, they will not have as a lot of an influence in your firm’s future success.

Get aware of the negotiation course of

Keep in thoughts that you will not be drafting a term sheet — the investor will. If you are fortunate, you may have a number of buyers vying to be the lead, so you may obtain competing term sheets. The phrases you set along with your lead investor decide the phrases you may set with different buyers collaborating within the spherical, mentioned Bouchra Ezzahraoui, cofounder of New York City-based jewellery firm AUrate, which launched in 2015 and raised $2.63 million in a seed funding spherical.

So, precisely how lengthy does this entire course of take? Dave Kimelberg, managing associate at Kimelberg PLLC, a New York City agency that gives authorized counsel to entrepreneurs and buyers, mentioned that if your organization’s in demand, it might take only a week. Otherwise, VCs will not be incentivized to maneuver as rapidly and negotiations would possibly take months.

Read extra: A startup founder who was rejected 148 instances by VCs made these 2 small adjustments to her pitch, and she’s since raised almost $30 million

The term “business standard” means “how things are typically done.” If one thing on the term sheet is not enterprise customary, be sure you ask about it and the way it will profit the corporate, Ezzahraoui mentioned.

For instance, Kimelberg mentioned term sheets right now are sometimes two pages lengthy. If an investor sends you a 10-page term sheet, it is on you (and your lawyer) to determine precisely why.

Then once more, you could very properly need to deviate from enterprise customary in some portion of the term sheet. Just as a result of one thing is enterprise customary “doesn’t mean it’s how it should be done,” mentioned Nick Martell, cofounder of every day finance e-newsletter MarketSnacks. (Martell is now managing editor of stories at Robinhood, which acquired MarketSnacks in March 2019 and renamed it Snacks.) “There’s always room for innovation in finance.”

That mentioned, should you do need to change business-standard phrases, you may must again that up with supporting proof, mentioned Jack Kramer, cofounder of MarketSnacks (now managing editor of stories at Robinhood).

Think lengthy term

Always understand that the term sheet you signal right now will affect future fundraising rounds. “That document will tag around for a long time,” mentioned Ezzahraoui.

Sacha Ross, a associate at Cooley LLP, a New York City legislation agency that advises high-growth firms and buyers, shared an instance of how myopic considering can come again to hang-out a founder. Say you agree to present the VC a 10% cumulative dividend on their funding, which means yearly they obtain 10% of their funding. “A cumulative dividend of 10% for a $1 million raise may not be that impactful,” Ross wrote in an e-mail to Business Insider. “But if that dividend is carried through to a $300 million growth round, the preference can build quickly.”

Ezzahraoui additionally advises founders to know the place they need their firm to go in two to 5 years, together with the buyers they need to goal of their subsequent fundraising spherical and what these buyers primarily care about. She encourages founders to consider whether or not their present term sheet presents any obstacles to touchdown these future buyers.

Remember that is the start of your relationship with buyers

“There’s this tendency to think of the fundraising as the milestone moment, as the capstone,” Martell mentioned. “The reality is that the fundraise is where the work just gets started.”

Chen mentioned the negotiation across the term sheets provide you with a glimpse into what will probably be like working with the VC going ahead. It’s the one time once you and the investor can be on reverse sides of the desk, so you may get to see how they conduct enterprise.

Read extra: The first-time founder’s final information to pitching a VC

Educate your self and search authorized counsel

Bouchra Ezzahraoui. Courtesy of Bouchra Ezzahraoui

As a first-time founder, you need to completely search authorized counsel throughout the fundraising course of. “If you are going to spend money on legal,” mentioned Megan O’Connor, cofounder and CEO of Clark, “this is the time to do it.” The New York City-based tutoring-software firm launched in 2016 and has raised $three.5 million in angel and seed funding rounds.

Ezzahraoui added that it is necessary to do your personal analysis — studying the literature, speaking to different founders — even earlier than assembly along with your lawyer, so you understand which inquiries to ask. And after all, do not be afraid to ask these questions. “You have to be confident enough in yourself to show when you’re not confident,” mentioned Martell.

A phrase of warning: Patrick McGinnis, serial entrepreneur and managing associate at impartial advisory agency Dirigo Advisors, mentioned attorneys can miss issues, too. “You must read everything extraordinarily carefully, and you must do all the math yourself and make sure all the math works out.”

Another choice is to ask the investor you are contemplating partnering with to present you a replica of a typical term sheet. It would not have to incorporate precise numbers, however Chen mentioned this offers you an thought of what it appears to be like like so you are not caught without warning or pressured to reply rapidly. Plus, Ross wrote, “Showing that you as a founder understand what’s important to you, and want to know what’s important to your investor, establishes your credibility.”

Take the doc significantly

A term sheet just isn’t legally binding. Typically, the founders’ and buyers’ attorneys will use the term sheet to draft different, legally binding paperwork, together with inventory buy agreements and shareholders’ agreements.

But as Martell warned, do not assume you’ll be able to change one thing once you get to the actual contract. “Once you agree to the term sheet, those are the general principles you’re agreeing to, and nothing should be in conflict with what’s in the contract,” he mentioned.

Weigh the significance of cash versus management

In their 2016 guide ” Venture Deals,” Brad Feld and Jason Mendelson, cofounders and managing administrators at Foundry Group, which invests in early-stage know-how firms, write that VCs care primarily about economics and management. Economics refers back to the return they’re going to get in a liquidation occasion (e.g., an IPO or acquisition); management refers to their capability to veto founders’ selections and form the destiny of the enterprise.

In truth, Feld and Mendelson write, if a VC is preoccupied with any phrases past the scope of economics and management, that exhibits you the way nitpicky they is perhaps down the road.

As for prioritizing cash or management, Ezzahraoui mentioned that generally you may need to go together with the investor at a decrease valuation in the event that they add extra worth to the enterprise or if the term sheet positions you for a better valuation sooner or later. As a founder, she mentioned, you’ve got a fiduciary obligation to maintain the very best pursuits of the corporate in thoughts.

“Liquidation preference” outlines how the proceeds can be shared in a liquidity occasion. According to “Venture Deals,” it is among the many most necessary phrases in a term sheet.

Capshare’s information to term sheets breaks down the usual apply: When an organization is bought, most well-liked stockholders are entitled to an quantity equal to what they invested earlier than different stockholders obtain something in any respect. Preferred shareholders can even convert their shares into widespread inventory and obtain money as a substitute.

Keep in thoughts the scale of your choice pool

Your “option pool” is the quantity of fairness you’ll be able to grant future workers. The measurement of the choice pool (sometimes between 10% and 20%) is taken into consideration within the firm’s valuation, in accordance with “Venture Deals” — which means an even bigger choice pool is not essentially advantageous.

Feld and Mendelson advocate getting ready an choice finances on your negotiation with an investor, itemizing all of the hires you propose to make between now and the following spherical of financing and how a lot fairness you may provide them.

Read extra: VC big Greylock, a Dropbox and Facebook investor, simply employed a brand new associate to workers its portfolio’s startups. Here’s the No. 1 trait she appears to be like for in govt candidates.

Consider board dynamics

Kimelberg encourages early-stage founders to maintain management of their board (which means a majority of seats) and to maintain it small. A 3-person board is advisable, he added, sometimes together with two representatives nominated by widespread shareholders and one consultant for the popular shareholders.

Whatever you do, make certain there’s an odd variety of seats to keep away from impasse.

Review protecting provisions

The protecting provision outlines how a lot management VCs have over your organization. For instance, you would possibly want their permission to promote the corporate, elevate one other spherical, concern extra inventory, or declare chapter.

Kimelberg warned that the voting majority threshold should not be too excessive — in different phrases, “you don’t want to have to chase down 70% of all the stockholders to get approval” for a sure choice. What’s extra, Kimelberg added, the protecting provisions on this term sheet will set a precedent on your subsequent spherical of financing.

Bring up any employment points

“Any material employment issues, I would also throw into the term sheet, make sure they’re there, so that you’ve surfaced them,” McGinnis mentioned. For instance, should you’re the founding father of one other firm, the term sheet would possibly point out that you’re going to spend 10% of your time there.

If you haven’t any aspect tasks, however that paragraph is within the term sheet anyway, it is doable the investor suspects you’ve got obtained one thing else occurring, in accordance with “Venture Deals.”